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In 2022, there has been a massive paradigm shift. Due to rising interest rates and fears that the economy may eventually slow down, the tech-heavy Nasdaq Composite has plunged 34% year to date.
By contrast, value-oriented stocks have delivered significant gains in this down market. Shares of healthcare products distribution company McKesson (MCK 0.49%) have soared a blistering 54% so far in 2022. And as impressive as the stock’s outperformance has been, there are reasons to believe that it can continue into next year and beyond.
It almost goes without saying, but medicines, vaccines, and medical supplies are of critical importance to the healthcare sector. And these life-saving products don’t just magically move from the manufacturer to pharmacies, hospitals, and patients. With a market capitalization of $54 billion, McKesson is the leading player in the medical distribution oligopoly along with AmerisourceBergen and Cardinal Health.
Buffett is a sucker for a wide moat. And since McKesson is nearly as big as its next two biggest competitors combined, it’s easy to see why Berkshire Hathaway owns a 2.3% stake in the company worth $1.2 billion. The healthcare products distributor is so dominant that the $276 billion in revenue that analysts are projecting for the current fiscal year is larger than the gross domestic product of many countries. This massive revenue base allows McKesson to navigate an industry with razor-thin profit margins and still report billions of dollars in earnings each year.
Looking out over the next five years, analysts expect McKesson’s non-GAAP (adjusted) diluted earnings per share to grow at a 10.5% annual clip. That’s because lengthening life expectancies and a growing global population should drive higher demand for the products that the company distributes. For context, McKesson’s annual earnings growth potential is superior to the medical distribution industry’s expected growth rate of 9.4%.
Image source: Getty Images.
McKesson’s 0.6% dividend yield is rather modest compared to the S&P 500 index’s 1.7% yield. Nevertheless, the company’s payout has tons of room to expand moving forward. This is because it is anticipated that McKesson’s dividend payout ratio will be just 8% for its current fiscal year ending March 31.
With such a low payout ratio, the company should have no difficulty retaining more than enough capital to fund growth ambitions, repay debt, and execute share buybacks. That is why I am confident that McKesson’s dividend growth will be more rapid than earnings growth over the medium term. That could translate into an annual dividend growth rate in the teens for the foreseeable future.
McKesson has blown the doors off the broader market in 2022. Surprisingly, the stock could have more upside ahead into next year and beyond. That’s because the valuation was so cheap at the start of this year that it is still sensibly valued — even after its huge rally.
McKesson’s forward price-to-earnings (P/E) ratio of 14.5 is only slightly above the medical distribution industry average forward P/E ratio of 13.8. The stock won’t be able to repeat 50%-plus total returns in 2023. But given the company’s industry leadership and above-average growth prospects, this valuation could still very well lead to low-double-digit annual total returns.
Kody Kester has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool recommends McKesson and recommends the following options: long January 2023 $200 calls on Berkshire Hathaway, short January 2023 $200 puts on Berkshire Hathaway, and short January 2023 $265 calls on Berkshire Hathaway. The Motley Fool has a disclosure policy.
*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.
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